VIII Experience with Long-Standing and Extensive Capital Controls and Their Liberalization
- Akira Ariyoshi, Andrei Kirilenko, Inci Ötker, Bernard Laurens, Jorge Canales Kriljenko, and Karl Habermeier
- Published Date:
- May 2000
During 1994–97, China’s international reserves increased sharply from 5.8 to 11 months of imports, owing to a strong balance of payments and large-scale intervention to keep stable the nominal exchange rate of the currency against the U.S. dollar. The balance of payments weakened in the aftermath of the Asian crisis, but China was able to maintain the stability of the currency.
These developments occurred in the context of a financial system that has serious weaknesses,56 and of a regulatory framework for international transactions that remains substantially restrictive, though significant progress has been made since the mid-1990s in liberalizing current account transactions (China accepted the obligations of the IMF’s Article VIII in December 1996). The authorities plan to liberalize the capital account over the medium term. China’s relatively closed capital account has been considered by some commentators as an important element in its success in maintaining its commitment to a stable exchange rate in the difficult international environment of 1997–98.
Capital controls in China have generally favored longer-term over shorter-term inflows. Foreign direct investment accounted for 98 percent of the cumulative net inflows recorded in the financial account between 1990 and 1996. On the basis of BIS data, short-term external debt (on a remaining maturity basis) stood at about 35 percent of international reserves at end–1998. The bias toward longer-term flows may have helped to reduce the vulnerability of the economy to external shocks, such as the recent regional crisis. A combination of structural and economic factors is also believed to have reduced China’s vulnerability, including the larger size of the domestic market, the relatively earlier stage of financial sector development (which limits opportunities for speculative activities), and a strong external position.
While China was able to maintain the stability of the currency throughout the Asian crisis, capital outflows became an increasing problem in late 1997 and early 1998, driven by concerns of a devaluation of the renminbi, the falling differential between domestic and foreign interest rates, and increasing cir-cumvention.57 The current account remained in surplus and foreign direct investment remained strong, but the capital account deteriorated sharply and errors and omissions in the balance of payments remained high. As a result, the overall balance of payments surplus fell sharply, from $36 billion in 1997 to $6 billion in 1998.
In response to these developments, the authorities significantly intensified enforcement of exchange and capital controls, and moved to reduce circumvention. These measures involved enhanced screening of capital account transactions and increased documentation and verification requirements on current transactions to demonstrate that the transactions are in fact legitimate current transactions rather than disguised capital transactions. The measures were implemented with a view to safeguarding current account convertibility, and respecting the obligations under Article VIII of the IMF’s Articles of Agreement, which were accepted by China in December 1996. The measures aimed at preventing illegal capital outflows and, ultimately, maintaining a stable exchange rate. While the measures have reduced illegal activities, there were widespread reports that legitimate transactions have also been adversely affected.58 In addition, in June 1999 the authorities restricted overseas yuan transactions by prohibiting domestic banks from accepting inward remittances in domestic currency.59 The authorities motivated the measures by the need to facilitate the compilation of balance of payments statistics. Some observers noted that the move might also help prevent the illegal movement of yuan out of China and might have been part of an effort to clamp down on offshore trading of the yuan by Chinese financial institutions.
In an effort to reduce financial risks and support the development of a sound business environment, the authorities also took measures to facilitate the more efficient operation of exchange controls. These included steps to increase the transparency of the regulatory framework; the introduction of a rating system for foreign trade companies; the establishment of a computer network to speed up screening of documentation for imports; and severe penalties for fraudulent behavior. These measures are expected to reduce the burden on foreign trade enterprises of the stricter enforcement of exchange controls, and of the laws and regulations for underlying transactions. While in the short run these measures had adverse consequences for foreign investors’ sentiments, the authorities expect that in the long run they will help enhance the business environment for legitimate transactions. By limiting the scope for smuggling, the measures are also expected to boost fiscal performance.
Following the introduction of the measures, transactions reported as imports in the balance of payments showed an increasing trend in January 1999. Possibly owing to a substitution of recorded for unrecorded imports, foreign exchange reserves showed small increases in the second half of 1998; and the authorities reported stronger fiscal performance in the most recent period. It is, however, too early to draw firm conclusions regarding the effectiveness of the measures.
Since the external crisis of 1991, India has undertaken economic reforms, including partial capital account liberalization, to begin reversing several decades of inward-looking and interventionist policies. These reforms included the virtual abolition of the industrial licensing system, a marked reduction in trade barriers, and a wide-ranging liberalization of current international payments (with the acceptance of Article VIII status in 1994). Capital account policy was reoriented toward reducing reliance on short-term and debt-creating flows (such as foreign currency deposits by nonresident Indians), while encouraging foreign direct investment and portfolio equity flows. Restrictions on these inflows were loosened first, followed by a partial liberalization of debt-creating flows, derivative transactions, and capital outflows.
Capital account liberalization has thus been part of a broad-based program of economic reform. Prudential regulation and supervision of the banking system have been strengthened and in many respects now conform to international standards; the regulation of securities markets has been thoroughly modernized; the government’s reliance on central bank financing has been curbed; and the central bank is making greater use of indirect instruments of monetary policy. However, a number of problems remain, including state ownership and control of most of the banking system, some shortcomings in prudential regulation and supervision, and government-directed credit policies.
For the most part, capital controls in India have been quantity based rather than market based, and administratively enforced. They appear to have been largely effective in limiting measured capital flows. The extensive controls that still remained in force during the Asian emerging markets crisis, particularly the limits on short-term external debt, may have helped to protect India from financial contagion; and their orientation toward limiting the country’s external debt was presumably significant. Other factors probably played a role as well: notably, a flexible exchange rate policy, ample foreign exchange reserves, and the fact that international trade and financial linkages are comparatively limited (reflecting the size of the country and the legacy of the economic controls that were long in place). However, the capital controls in force during the 1970s and 1980s did not protect India from a marked buildup of external official debt and severe balance of payments crises in 1980 and 1990–91. With the reorientation of capital account policy toward non-debt-creating inflows and foreign direct investment since 1991, however, external indebtedness has declined markedly, from a peak of 38 percent of GDP in 1992 to less than 25 percent of GDP in 1998.
There are indications that India’s wide-ranging capital and other economic controls may have reduced economic growth compared with other Asian economies with a more open economic system. It is difficult to demonstrate this rigorously, though the economic liberalization program begun in 1991 has been followed by probably the most robust growth India has enjoyed since independence.